The Dow Jones Instustrial Average rose above $14,000 last week. To some this new high means higher prices ahead and to others it is reason to sell. Price as a measure of performance or what something is worth has been a 60yr frustration. Price is what many on Wall Street and is what academia teaches is the means to value the market. My approach is much more steeped in fundamental economic returns!

Price can be shown to be a measure more of market psychology than a measure of true valuation. Believing that price when compared to price history tells one something about the relative value of something misses entirely information concerning economic return. One first must have a measure of economic return and then apply it across market history to test its usefulness/reliability. This is the approach I have taken with the Prevailing Rate(a measure of market return) and SP500 Intrinsic Value Index(the price of the SP500 calculated from earnings returns capitalized by the Prevailing Rate). When one does this one can identify when the SP500 appears fairly valued and when it is not.

Any guesses as to how often the SP500 (SPY) is fairly valued?

Using the SP500 Intrinsic Value Index one comes to the conclusion that the SP500 (.inx) is fairly valued about 1% of the time (perhaps less).

When is the SP500 closer to fair value?

SP500 is near or at fair value only during market bottoms. Most of the time since 1995 the market has been grossly overvalued by investors chasing price trends, i.e. Momentum Investors.

What is the value of the SP500 Intrinsic Value Index today?

$1,737!! Or today’s SP500 is 14.8% underpriced.

It should come as no surprise that markets are driven by considerable market psychology. The current chart of the SP500 vs. S&P 500 (.INX) Intrinsic Value Index is shown below. The inflation measure used in the calculation is the Dallas Fed’s 12mo Trimmed Mean PCE and spans 1978 to Present. It is deemed a more reliable measure of inflation than its predecessors and is the reason the chart does not go back further than 1978.

The SP500 Intrinsic Value index is based on economic return. Since 1995 it has been very useful to be able to differentiate between what is a fair economically based price and what is a price based on market psychology. It is in 1995 when the visible effect of Hedge Fund momentum investing began to so influence market prices. We have had two major market rises and collapses. Rises well in excess of fair value occurred in 2000 and 2007. Each subsequent collapse returned to fair value! The pattern causes on to ask what caused the rises and why did fair value prove to be a rough market low. The answer comes from extensive reading of the many investors who comprise markets.

It is the value buyers of the likes of Warren Buffett who recognize economic returns who become the active buyers whenever the SP500 comes near the SP500 Intrinsic Value Index. It is these investors who cause markets to form lows eventually turning higher. What Buffett does is to buy a stream of future expected returns(he uses a mental average) in the context of a similar stream of returns generally available in the economy(Real GDP + Inflation). This is a simple rate of return comparison. What is not simple is the fact that Warren does this all in his head and has never explained it as I just have.

Every other investor falls into the camp of momentum traders. It is these investors who believe in “The Efficient Market” and “The Invisible Hand” and buy and sell stocks based on the current stream of economic, geopolitical and taxation news. They are “News Investors”. If the news is good, they buy? If the news is bad, they sell! They believe that the market correctly prices all securities all the time and incorporates all the information that can be known instantly into price. Basically, the market is composed of 2 types of investors, a very few value investors like Warren Buffett (who I believe make up about 1% of all investors) and the rest who seek to imitate the trades of the 1% and the momentum traders who trade on price changes. Warren Buffett does not believe any of this and has written extensively over the years as to why his approach differs, yet Warren has never explicitly explained exactly what it is that he does. My guess is it is precisely because he does all of it in his head, knows what to do, but can’t articulate it. He sees it as one huge theme, somewhat like Einstein doing math by mixing colors in his head. Genius is like this!

About the author

Todd Sullivan is a Massachusetts-based value investor and a General Partner in Rand Strategic Partners. He looks for investments he believes are selling for a discount to their intrinsic value given their current situation and future prospects. He holds them until that value is realized or the fundamentals change in a way that no longer support his thesis.
His blog features his various ideas and commentary and he updates readers on their progress in a timely fashion. His commentary has been seen in the online versions of the Wall St. Journal, New York Times, CNN Money, Business Week, Crain’s NY, Kiplingers and other publications. He has also appeared on Fox Business News & Fox News and is a RealMoney.com contributor. His commentary on Starbucks during 2008 was recently quoted by its Founder Howard Schultz in his recent book “Onward”. In 2011 he was asked to present an investment idea at Bill Ackman’s “Harbor Investment Conference”.